Loan default

[Gilmore]

A participant takes out a three year loan for $5,000 and begins making payments through payroll. The Plan Administrator sets the loan schedule up through their payroll system which is preset to stop payments when a specified amount is paid back, presumably the total amount of principal and interest. The Plan Administrator inadvertantly sets the max payback to only the $5,000 principal amount so payments stop once that cap is met. Since loans are reconciled only once a year the mistake is not found out until after the loan is in default.

What are the options for correction, and please let me know if additional info is needed to determine.

Thanks so much.

[g8r]

I haven't this issue come up before, but here's my stab at an answer.

As Ricky Ricardo would say to the Plan Administrator "...you have some 'splaing to do.."

The loan is in default and it's taxable. I think that's the position the IRS will take. Because the statute provides the results (taxation), it's not something you can handle through EPCRS. One other consideration, it's possible the IRS could argue that it was taxable when made. The reason is because you didn't have level amortization over a 5 year period.

Maybe others will have some creative ideas ...

[Gilmore]

Thanks for your input. We were planning to handle it as a deemed distribution but wanted to make sure we weren't over looking any other options.

[R. Butler]

Even with the repayment calculation error, are you sure that you are outside of the cure period? Even if interest was as high as 10%, it seems like he would only be about a month or so behind.

[Gilmore]

The last payment made on this loan was in the fall of 2001. It was not caught in 2002 as he was still within the grace period when loans were reconciled. Further confusing matters was that he took a second loan right after the payments stopped on the first so I can only assume the Plan Administrator thought the payments had resumed.

[Guest Paul Kelly]

I would not concede immediately that an administrative mistake in collecting this loan is fatal (vis a vis deemed distributions). The post indicates that there is primarily a payroll system goof; and that error could be fixed by having the borrower catch up the past due amounts now.

I think g8r makes a great point about there being an amoritization failure, but that issue should be determined by whatever the promissory note provided. In other words, if the written note was Kosher, and "only" the collecting was in error, then that note would have passed muster facially.

I believe the default and non-payment requirements under IRC 72(p) contemplate a true "flaking out" by the borrower, not an under-collection that was caused by the employer's payroll system. In fact, if the note speaks to payroll withholding as being the primary vehicle for repayment, then what was the poor borrower to do??

Absent other facts, I would advise the parties to have the borrower catch up on that note asap. But I don't concede that the borrower "defaulted" just because the totality of the circumstances show that he has underpaid what the note required.

Super question!

[R. Butler]

I believe the default and non-payment requirements under IRC 72(p) contemplate a true "flaking out" by the borrower, not an under-collection that was caused by the employer's payroll system. In fact, if the note speaks to payroll withholding as being the primary vehicle for repayment, then what was the poor borrower to do??

Absent other facts, I would advise the parties to have the borrower catch up on that note asap. But I don't concede that the borrower "defaulted" just because the totality of the circumstances show that he has underpaid what the note required.

This issue has been discussed before.

http://www.benefitslink.com/boards/index.p...=20&t=17499&hl=

[Gilmore]

Thank you both for your recent replies, and thank you for the link, R. The link provided in the previous discussion did not work due to the software changes with the message boards, but can I assume that the same type of discussion resulted...some saying it could be fixed, others saying it could not?

Our first reaction was that the loan was in default. However, because the stoppage in payments was clearly the fault of the Plan Administrator not correctly coding her payroll system, I thought there might be some leeway and decided to post the question.

Anyway, the Plan Administrator has discussed the situation with the participant, admitting that she made the error, and the participant is ok with the distribution. Luckily it was a fairly small amount.

One other question...

The participant has more than one loan, including the one that was defaulted. Since the payments on the loans are made from payroll deductions, would the new rule on subsequent loans that is in effect after Jan 2004 have come into play (assuming we are in 2004)?

Thanks again.